Utility

One concept I’ve touched on with many of my pillars and “bad guy quotes” since we started the podcast a year and a half ago is “Utility.” It’s a concept that is used in economics fairly regularly but I don’t think that the average citizen has a real firm grasp on what it truly is. And after doing a bunch of research, there doesn’t even seem to be a good resource anywhere that I have found that talks about what it philosophically means. All of the economics blogs and articles I’ve read delve too quickly into how to quantify it and fun graphs and calculations. So I wanted to take a pillar and really dive deeply into what it means. I don’t even know if the way I look at it is truly the proper way to describe it, but it’s one of those concepts that is really worth thinking about because you can apply it to so many situations to make a little more sense of why things cost what they cost, and how much value we derive from things.

It’s almost more of a psychological concept than economic, at least the way I see it, and can be applied to many situations that help us better understand why things are the way they are.

“Utility” is the measure of satisfaction we gain from consuming something. Now a while back, Perek did a great pillar about money and how it’s an indicator of value, but there are some problems with using cost and prices to determine the value of things. One of the biggest problems is that price is a crappy way to measure our satisfaction because everyone’s preferences and what money means to people is different. A $100,000 car would give me a larger amount of satisfaction than it would for Bill Gates. A $3.00 hamburger means a lot less to me than it would for a starving kid from India. You get the picture.

Taken even a step further, the satisfaction we derive from something changes even for a single person based on our circumstances. An ice cold beer provides more satisfaction for me, for instance, after I’ve just mowed the lawn on a 100 degree day, than the 9th beer I have at the end of a night of partying. So even though that beer “costs” the same in both situations, the first beer after mowing the lawn is “worth” more to me than that 9th one. The lawn beer has more “utility.”

You also can’t measure satisfaction of less tangible things with money. The feeling of satisfaction I get from a sunny, crisp fall day is not something that I could easily attach a monetary value to, but it definitely still has “value.” So it’s helpful to have a concept like utility to talk about our relative satisfaction.

Economists even have units that they can measure utility with, and they came up with the creative name of “Utils.” Using utils is a meaningful way to quantify these abstract concepts like a sunny day, or a cold beer. That lawn beer might be worth 100 “utils” whereas that 9th beer at the end of the night might be worth only 5 utils to me. Heck, if that beer gives me a hangover the next morning, I might even say that it has “negative utility” and I could assign a value of -10 because it detracted from my overall sense of satisfaction and well-being.

So these utils are a fun thing to play around with and economists love drawing graphs that have utility curves. I don’t like to get too crazy with trying to quantify these abstract concepts, but as an example, I could draw a beer utility curve that describes how much I value each beer as I consume them during a night. It would rise steeply at first, but with each successive beer I drink, the “Marginal Utility” of each beer gets less and less until it finally goes negative when I’ve had too much. So the fact that “at the margin” each beer is worth less to me, is the concept you might hear called “Diminishing Marginal Utility.”

So that’s as deep as I care to get right now in terms of really trying to quantify it. But again, “utility” offers us a way to talk meaningfully about our preferences.

Once we have a good understanding, (To use a term from my college calculus professor, “you can feel it in your guts”) the real power of utility is to start talking about the utility of money. So just like having a beer gives me a certain amount of satisfaction, so too, does having $5 in my pocket. Why? Because of all the possibilities of stuff I could buy with that $5 that would also give me satisfaction.

A graph of the utility of money would look very much the same as my beer graph, it would be diminishing, but in most cases would always be positive. I get more satisfaction from having my first dollar in my pocket (at the margin) than my one millionth dollar.

So now I have $5 in my pocket and I gain a certain amount of satisfaction (utils) out of, and then there’s the world that has all sorts of goods and services I could buy that would also give me satisfaction if I bought them, like a beer. Let’s say having $5 in my pocket gives me 50 utils. If I am a perfectly rational person, when I see something that will give me more than 50 utils of satisfaction, I will go ahead and buy it.

I should pause here because this is a very controversial point in the world of micro-economics that I shouldn’t gloss over. There has always been a huge debate about if humans (or markets) are truly rational. Lots of arguments back and forth, but this is why I think beer is a pretty good example. If I really knew after having 8 beers, that that 9th beer is going to give me zero utility, I shouldn’t really buy it, but the reality is that at that moment I’m probably not thinking rationally and may make a decision that gives me negative utility. But I still think it’s a very valuable concept that we can use to frame current events and debates in a meaningful way. If you want to dig a little deeper, listen to our very first podcast on the efficient market theory that touches on if the market is rational.

So let’s explore what sprinkling the concept of utility can do to help us rationalize and come to grips with the prices we pay for things. Let’s stick with beer first, but let’s look at it in the frame of my favorite topics; baseball!

A couple years ago, the Minnesota Twins got a new stadium to play in, and if you are ever talking to someone about the first time they went to this new stadium, at some point during the conversation, they are gonna say something like “Man what a beautiful stadium and a great game, but man, I had to pay $7.50 for every beer I had! What a rip-off!” It doesn’t make logical sense to us that we should pay that much for 12 oz of beer that we could easily get for less than half that price if we buy it at the liquor store and drink it at home. It doesn’t seem fair, until we take a step back and contemplate the satisfaction we are getting out of that beer. I don’t know about you guys, but I derive way more utils out of a beer at a ballgame with my buddies than I do if I’m drinking it alone on my couch at home while I’m watching survivor. They bring it right to me, I feel like more of a man, I look cool drinking it etc. It’s WORTH way more to me at that ballgame so I’m willing to pay way more for that same 12 oz of beer. If I didn’t think it was worth it, and it was more valuable for me to keep that $7.50 in my pocket at the game, that’s ok too. If I’m rational, I’m going to make the choice that maximizes my utility.

Here’s another real world example of utility of free time. Little did you know, that our very own Perek whether he knew it or not, had a real strong concept of utility. When we were all in college and living together, from time to time Perek would amass a large stack of dirty laundry. And on multiple occasions, rather than washing those clothes so that he could be a meaningful member of society, he would take a trip to wal-mart and drop $10 on a brand new golf shirt and 3-pack of undies. To the casual observer, this looked like INSANITY! People gave him a lot of crap about this, but if you knew Perek, it made total sense because of his utility preferences. The satisfaction Perek derived from doing a load of laundry, was simply way less than the satisfaction of buying a new shirt. Even dis-regarding the straight up monetary cost of doing a load of laundry, you had to find quarters, take time to load all your clothes up, schlep them to the hot washing machine room, wait for an opening, then come back when they are done, wasting a lot of free time. It simply gave him greater overall satisfaction (at the margin) to just buy a brand new shirt, then spend all that time dealing with laundry and keeping that $10 in his pocket. This was a specific micro-economic decision that he made, that might be totally different for most people, but if that was how he valued his scarce resources (time and money), we see that he probably made the right choice for himself.

A third way that I think thinking about satisfaction and value in terms of Utility is when people start to try and give me advice. Because remember, Utility is a MICRO economic concept and everyones decisions and preferences may be different. And this sage advice always tends to be on big ticket items. I experienced it the last time I bought a car. About 5 years ago, my truck broke down and I needed to get a new vehicle. I was pretty fresh out of college so didn’t have a ton of money, so I leased a brand new truck. Most people that like to give advice already would be jumping over themselves to tell me that that was a horrible financial decision, but I really put them over the edge when my lease was up and I bought out the residual value. “Mitch! Do you realize that if you total up all the payments you made plus the residual value you paid, you probably ended up paying thousands more dollars than the car would have been had you just bought it?! You should have bought a used car and driven it until it died. That is the way to get the most for your money!” And yes, I readily admit that if I ran solely the mathematical analysis, this looks like I made a bad decision. But let’s look at some things that are specific to me that I got utility from:

I know nothing about cars. I don’t enjoy learning how car parts work. If something happens to my truck, I’m going to have to take it in and pay for repairs.

I know that I’m the only one to ever drive my truck. It had 12 miles on it when I drove it off the lot. It is worth something to me that I’m not buying this thing off a sketchy guy on craigslist that might have filled the tank with sawdust. That piece of mind gives me satisfaction! Gives me utils!

I hate to haggle and am not good at it. At the end of my lease, there was a non-negotiable residual number that I could simply pay, and get the car. No haggling over how much the trade in was, the dude going back and forth with his manager trying to make it seem like he’s getting the best deal for me, high pressure sales tactics etc. There was value for me driving in and literally just writing my residual value check and walking back out in a half hour and having them mail me the title.

Now this decision would probably be a lot different if I were gearhead who loved getting the best deal. I would have scoured the internet looking for the best deal, and then haggled until the seller was crying. That’s the beautiful thing about utility. It’s micro-economic and may be different for every person. Here’s a great blog and another explanation of one guy who always buys new cars because he VALUEs certain things differently than the conventional wisdom tells him to.

3 Comments

Just had a conversation with my husband about utility. Never thought I’d say that! We have a basic problem of utility. I assign high utils to things I buy and he assigns high utils to having money in our bank account. This is why we are constantly arguing about purchases. I think if we can understand each other’s utility amounts, it could help…thanks GGTK!!